The Big Flaw Few are Talking About in Fintech

Online lending companies were the darlings of the banking business less than a year ago.

Now investors—both those who fund the loans and those who buy the stocks of the companies that make up the industry—are quickly falling out of love with the fintech start-ups for good reason.

The biggest online lender is Lending Club, followed by Prosper and then Social Finance Inc (Sofi). And until very recently, these firms were making a push to get more borrowers on board. This year Sofi bought its first Super Bowl ad, encouraging people to go to the company’s website to find out if they are “great.”

Last week, though, Fitch released a report that reiterated the growing concerns about the banking upstarts. “The marketplace lender business model has yet to endure either a full interest rate cycle or credit cycle,” the report said.

The problem, according to Fitch, is that online lenders are taking on riskier borrowers than they originally suggested they would. And they have perhaps been relying too much on credit scores, which the fintech lenders appear to be recognizing. “Pockets of recent credit underperformance beyond initial expectations have likely contributed to the ongoing refinement of underwriting models, including further de-emphasizing of the use of traditional FICO scores in certain instances,” Fitch said in its note. In other words, traditional banks may actually be able to assess borrowers with more accuracy, then the data-driven fintech lenders.

Loan delinquencies back this up. It takes a while to get a decent read on the overall credit quality of a loan book. Though Lending Club (lc) is on the right trajectory, its write-offs are still relatively very high. Loans issued in 2008 had a charge off rate of more than 14% after three years. Those issued in 2012 had charge offs of around 7% after three years, less, but still much higher than banks. For reference, Citigroup’s loan losses are around 2%.

Fitch’s note points out another risk: online marketplace platforms aren’t actually lending, rather they typically match up potential borrowers with the source willing to fund the money—such as hedge funds, institutional investors, or even traditional banks. As a result, the “lack of alignment of interest due to separation of lenders and originators . . . present additional challenges,” according to Fitch.

This arms length relationship enables companies like Lending Club to earn oodles on fees for a while, and not actually have to be responsible if the loans go bad.

That can work for a while. The trouble is that if quality is bad, the actual lenders, that is the hedge funds and others that fund the loans are going to stop coming back for more. And that’s exactly what’s going on. “As institutional demand waned in recent months, marketplace lenders began to seek alternative funding sources to sustain loan originations,” Fitch says.

To keep the business churning, Sofi, for instance, has launched its own in-house fund. What’s more, as long as they keep their investment threshold below 50% of the ownership structure, they don’t have to report the loans on balance sheet.

Starting to sound familiar? Mortgage lending had a similar life cycle: incentives weren’t aligned, and lending standards deteriorated. When lenders withdrew, banks tried to shore up their credit quality, but it was too late, so they started to push out loans at their own expense. Shareholder didn’t even know what they owned because banks didn’t always have to record it.

Sure, the online lending business doesn’t come close to the size of the mortgage business, so it’s not likely to cause as big a crisis, even if it were to go bust. Still, at the very least, companies like Lending Club look to be taking the trajectory of banks, and with more pitfalls. Yet shares of Lending Club, at a recent $7.40, trade at 36 times 2017 earnings, while JPMorgan Chase (jpm) trades at a quarter of that multiple. It isn’t just the lenders that will suffer losses.

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